Scandal of the week: backdating options
When I mention "corporate social responsibility" to someone unfamiliar with the field, the most common response (besides "Is that an oxymoron?") is to mention Enron and related corporate-governance scandals. It seems that governance gone bad has captured public attention more than any other issue. And just when I think they must have run out of news, recent issues of the Financial Times have reported the all-too-common practice of "backdating" options.
Stock options grant the right to own a certain number of shares of of stock, at a certain fixed price. They are worthless if the current market price is below the stock-option price (then you might as well buy your shares in the regular market), but if they can be extremely valuable if, for example, they allow one to buy $200 shares for only $100 each. Presumably, granting stock options to a CEO is an incentive for him/her to create shareholder value - because the CEO's own fortunes become highly dependent on the stock price. Some have argued this still doesn't make the CEO feel the pain of stock-price drops (and can therfore lead to excessive risk-taking), but overall the idea makes some amount of sense.
What doesn't make sense is to retroactively grant options. It's against the whole idea of incentives, because one already knows the price today and the price before. It's really just a way to mask CEO pay. Strictly speaking, it's not illegal - but it's deceptive.
Until 2002, it was possible for companies to backdate options so that, following a rise in the stock price, options were granted for an earlier date (and at a lower price). These options were therefore immediately valuable. After 2002, thanks to the Sarbanes-Oaxley legislation, options must be reported within two days, making backdating virtually impossible.
To date, according to the Financial Times (see, for example, "Options Backdating Scandal Snowballs, 6/14/06, p. 12) about 40 companies are under formal investigation or holding internal inquiries. The results of these investigations are expected to reveal abuses across the Fortune 500.
Soaring CEO pay has already become an area of concern in the past few years, and the options backdating scandals will likely fuel more criticism. Then again, perhaps CEO pay has been rising to offset the decline in backdated options since 2002... a case of two wrongs making a right?
Stock options grant the right to own a certain number of shares of of stock, at a certain fixed price. They are worthless if the current market price is below the stock-option price (then you might as well buy your shares in the regular market), but if they can be extremely valuable if, for example, they allow one to buy $200 shares for only $100 each. Presumably, granting stock options to a CEO is an incentive for him/her to create shareholder value - because the CEO's own fortunes become highly dependent on the stock price. Some have argued this still doesn't make the CEO feel the pain of stock-price drops (and can therfore lead to excessive risk-taking), but overall the idea makes some amount of sense.
What doesn't make sense is to retroactively grant options. It's against the whole idea of incentives, because one already knows the price today and the price before. It's really just a way to mask CEO pay. Strictly speaking, it's not illegal - but it's deceptive.
Until 2002, it was possible for companies to backdate options so that, following a rise in the stock price, options were granted for an earlier date (and at a lower price). These options were therefore immediately valuable. After 2002, thanks to the Sarbanes-Oaxley legislation, options must be reported within two days, making backdating virtually impossible.
To date, according to the Financial Times (see, for example, "Options Backdating Scandal Snowballs, 6/14/06, p. 12) about 40 companies are under formal investigation or holding internal inquiries. The results of these investigations are expected to reveal abuses across the Fortune 500.
Soaring CEO pay has already become an area of concern in the past few years, and the options backdating scandals will likely fuel more criticism. Then again, perhaps CEO pay has been rising to offset the decline in backdated options since 2002... a case of two wrongs making a right?
posted by Melissa Paschall at 6/14/2006 10:06:00 AM
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